Three themes (and what they mean) for income investors

As markets and global macroeconomic conditions have shifted, we believe that there are three themes income investors may want to examine more closely. Below, we explore these themes and detail the potential investment implications.

1. Beware recession complacency

Divergences in economic activity have remained a dominant theme across markets over the year-to-date period. At the time of writing, North America has shown greater relative economic momentum, but prospects have faltered in Europe and in China. In Europe, we have seen a sharp rise in interest rates drag on economic activity. At the same time, the ongoing weakness in global manufacturing sectors has hit European countries much harder than others given their larger share of industrial exposure. Meanwhile, China has seen a sharp deceleration in activity. Private businesses and consumers seem to lack optimism and are holding back on capital expenditure and purchases. In addition, the recovery in the large residential real estate sector has been very slow.

On the other hand, the recent outperformance of the US economy has been a surprise relative to consensus expectations. In fact, the recent period has seen many economists revise their forecasts for a recession in 2023. This said, there’s much debate around the path forward. At present, our base case is that we’re likely to see a downshift in growth prospects for the region due to weakening consumer credit, falling profit margins and potential future weakness in the labour markets — even if we may not see a technical recession.

We also believe we’re likely to see more significant financial sector and refinancing risks in the US over the next few years when more than US$3 trillion of debt comes due. We believe this is likely to have a large impact on the corporate sector, leaving credit assets vulnerable in the face of the potential drag on profit margins resulting from higher interest rates.

2. Consider being “focused yet diversified” in the search for return

This year has continued to see mixed macroeconomic data and a wide range of potential outcomes, with many surprises along the way. Perhaps the biggest surprise of all has been in global stock markets, with the strong recent performance of cyclical stocks and the sharp rally in US mega-cap technology stocks. While mega-cap technology is likely to benefit from the rollout of AI-enhanced products and services, the rally in cyclical stocks is more difficult to explain.

However, in our view, earnings growth estimates are unlikely to remain in double-digit territory against an economic environment of slowing growth. Current earnings growth estimates are also at odds with the very high valuation multiples that many stocks demand — even though a deteriorating macro environment may challenge their growth prospects.

Against this backdrop, we believe it’s important to take a diversified approach to security selection, particularly within equities. Instead of relying heavily on cyclicals versus defensives or growth versus value, we believe there are attractive opportunities for alpha generation across a wide range of different asset classes that may be captured by active managers. In our view, investors who place a greater emphasis on security selection may be better positioned for the period ahead.

For example, as a result of capital expenditure in AI we are positive on both select cyclical opportunities in the information technology sector, where valuations still look attractive, as well as the US homebuilding sector, where we see a strong supply/demand imbalance for single-family homes. On the other hand, we also see attractive opportunities within defensive stocks that have attractive fundamental attributes and a low correlation to global equity markets in order to provide diversification benefits.

What does this mean for income investors?

• They may do well to avoid large portfolio factor biases.
• High-conviction opportunities that have complementary risk profiles may be beneficial.
• Focusing on risk metrics such as correlations during portfolio construction could be helpful.